If you run a small business in India with ten or more employees, gratuity is not optional. It is a statutory payment owed to eligible employees when they leave your company, and getting the calculation wrong is one of the most common (and expensive) payroll mistakes small employers make.<\/p>\n\n\n\n
This guide walks through exactly who qualifies, how the amount is calculated, what changed under India’s new Labour Codes, and how much of it is taxable. We will also work through real examples so you can check your own numbers by hand before running them through the Gratuity Calculator.<\/p>\n\n\n\n
Gratuity is a lump sum payment made by an employer to an employee as a form of recognition for long term service. It is paid when employment ends, whether through resignation, retirement, termination, death, or disablement.<\/p>\n\n\n\n
Gratuity in India has historically been governed by the Payment of Gratuity Act, 1972. As of November 21, 2025, this Act (along with 28 other central labour laws) was repealed and its provisions were absorbed into the Code on Social Security, 2020, one of four new Labour Codes notified by the central government. The core formula and most eligibility rules carry over largely unchanged, but a few important details have shifted, and we will flag each one as we go.<\/p>\n\n\n\n
One thing worth knowing upfront: implementation of the Labour Codes has been rolling out unevenly across states through 2026, with central rules finalized in May and several states still finalizing their own. The rules described in this guide reflect the framework as it currently stands, but if your business operates in a state that hasn’t yet notified its rules, you may still be working under the older Payment of Gratuity Act provisions in practice. When in doubt, confirm your state’s current status with a compliance advisor.<\/p>\n\n\n\n
Gratuity applies to any shop, factory, or establishment that has employed 10 or more people on any day in the preceding 12 months. Here is the detail small business owners frequently miss: once your establishment crosses that threshold, the obligation continues even if your headcount later drops below 10. You do not get to opt back out.<\/p>\n\n\n\n
For most employees, gratuity becomes payable after 5 years of continuous service, and applies on:<\/p>\n\n\n\n
There is a well known workaround worth understanding, though it comes with a caveat. Under Section 2A of the Act, an employee who completes 240 working days in their fifth year of service is often treated by courts as having completed a full year, which can bring their total service to the 5 year mark even if their exact tenure is closer to 4 years and 8 months. This interpretation has been upheld in multiple High Court rulings, but it is not a guaranteed entitlement written explicitly into every employer’s policy. Do not reject a borderline claim automatically. Count the actual days worked in the final year before deciding.<\/p>\n\n\n\n
This is the single most important update for small businesses to know in 2026. Under Section 53 of the Code on Social Security, fixed-term and contract employees are now eligible for pro-rata gratuity after just 1 year of continuous service, not 5. If you hire on fixed-term contracts of a year or two, which many small businesses do to manage seasonal work or project-based roles, this materially changes your liability. A one-year contract that previously carried zero gratuity obligation may now require a payout at the end of the term.<\/p>\n\n\n\n
For establishments covered under the Act (10 or more employees), the standard formula is:<\/p>\n\n\n\n
Gratuity = (Last Drawn Salary x 15 x Number of Years of Service) \/ 26<\/strong><\/p>\n\n\n\n For employers who pay gratuity voluntarily but are not covered under the Act, the divisor changes from 26 to 30, which produces a slightly lower payout for the same tenure and salary.<\/p>\n\n\n\n A few details matter more than they might seem to at first glance:<\/p>\n\n\n\n “Last Drawn Salary” means Basic pay plus Dearness Allowance (DA) only.<\/strong> It does not mean gross salary, and it does not mean CTC. Using the wrong salary figure is the most frequent calculation error small businesses make, and it usually inflates the payout well beyond what is legally owed, or in rarer cases, underpays it.<\/p>\n\n\n\n The 50% Wages Rule now affects this calculation directly.<\/strong> Under the Code on Wages, allowances cannot make up more than 50% of an employee’s total remuneration. If your current salary structure has a low basic pay propped up by large allowances (a common way small businesses have historically kept statutory contributions down), the excess above that 50% threshold now gets reclassified as “wages” for the purpose of gratuity and PF calculations. In practice, this means the Basic plus DA figure used in your gratuity formula may now be higher than what your payslip currently shows as basic pay, and your actual gratuity liability may be larger than you expect. If you haven’t reviewed your salary structures against this rule yet, this is worth doing before your next resignation or retirement.<\/p>\n\n\n\n Partial years are rounded, not prorated, for standard employees.<\/strong> If an employee’s service in their final year exceeds 6 months, it rounds up to a full year. If it is 6 months or less, it rounds down. This rounding rule does not apply the same way to fixed-term employees under the new pro-rata provision, where the amount is calculated proportionally to the actual period served.<\/p>\n\n\n\n An employee resigns after 8 years of continuous service. Their last drawn salary (Basic + DA) is Rs. 40,000 per month.<\/p>\n\n\n\n Gratuity = (40,000 x 15 x 8) \/ 26 = Rs. 1,84,615 (approximately)<\/p>\n\n\n\n Two employees, same salary of Rs. 35,000 (Basic + DA), different tenures:<\/p>\n\n\n\n Employee A served 6 years and 7 months. Since 7 months exceeds the 6 month threshold, this rounds up to 7 years. Gratuity = (35,000 x 15 x 7) \/ 26 = Rs. 1,41,346 (approximately)<\/p>\n\n\n\n Employee B served 6 years and 4 months. Since 4 months falls short of the threshold, this rounds down to 6 years. Gratuity = (35,000 x 15 x 6) \/ 26 = Rs. 1,21,154 (approximately)<\/p>\n\n\n\n A three month difference in actual tenure results in a roughly Rs. 20,000 difference in payout. This is exactly why counting exact dates, not approximate years, matters.<\/p>\n\n\n\n A fixed-term employee completes a 2 year contract in full. Their last drawn salary (Basic + DA) is Rs. 30,000 per month.<\/p>\n\n\n\n Gratuity = (30,000 x 15 x 2) \/ 26 = Rs. 34,615 (approximately)<\/p>\n\n\n\n Before November 2025, this employee would have received nothing, since fixed-term workers needed 5 years of service like everyone else. Under the current rules, this payout is owed.<\/p>\n\n\n\n For private sector employees covered under the Act, gratuity received is exempt from income tax up to Rs. 20 lakh. This is a lifetime, cumulative limit across every employer an individual works for in their career, not a per-job allowance. If an employee already claimed Rs. 8 lakh in tax exemption from a previous employer, only Rs. 12 lakh of exemption remains available for future gratuity payouts, regardless of how the new amount is calculated.<\/p>\n\n\n\n Any amount received above the exemption ceiling is added to the employee’s taxable income and taxed at their applicable slab rate.<\/p>\n\n\n\n Government employees receive their entire gratuity payout tax free, with no ceiling, under a separate provision of the Income Tax Act.<\/p>\n\n\n\n As an employer, make sure your full and final settlement calculation correctly treats the exempt portion of gratuity when computing TDS. Applying TDS to the full gratuity amount, exempt portion included, is a common and easily avoidable payroll error.<\/p>\n\n\n\n Gratuity can be withheld, wholly or in part, only in specific circumstances defined by law, generally limited to termination for:<\/p>\n\n\n\n Forfeiture is not automatic even in these cases. It requires proper documentation and, in most instances, a clear termination order citing the specific misconduct. Employers should treat forfeiture as the exception, not the default response to a difficult exit.<\/p>\n\n\n\n Using gross salary or CTC instead of Basic plus DA.<\/strong> This is the single most common error, and it tends to significantly overstate the amount owed.<\/p>\n\n\n\n Assuming employees under 5 years are never eligible.<\/strong> Between the 240 day rule for permanent staff and the new 1 year rule for fixed-term employees, more of your workforce may qualify than you assume.<\/p>\n\n\n\n Forgetting that coverage under the Act is permanent once triggered.<\/strong> Dropping below 10 employees does not end the obligation.<\/p>\n\n\n\n Rounding tenure loosely instead of counting exact dates.<\/strong> As Example 2 shows, a few months of difference can change the payout by tens of thousands of rupees.<\/p>\n\n\n\n Not reviewing salary structure against the 50% wages rule.<\/strong> If your basic pay has historically been set low relative to total compensation, your actual gratuity liability is likely higher than your payroll system currently reflects.<\/p>\n\n\n\n Is gratuity mandatory for small businesses in India?<\/strong> Yes, once your establishment has employed 10 or more people on any day in the preceding 12 months, gratuity becomes a statutory obligation, and it remains one even if headcount later falls below 10.<\/p>\n\n\n\n Can an employee get gratuity before completing 5 years of service?<\/strong> Generally no, for permanent employees, with two exceptions: death or disablement waive the requirement entirely, and fixed-term employees now qualify for pro-rata gratuity after just 1 year under the Code on Social Security.<\/p>\n\n\n\n What exactly counts as “last drawn salary” for the calculation?<\/strong> Basic pay plus Dearness Allowance only. It excludes HRA, bonuses, and other allowances, and it is not the same as gross salary or CTC.<\/p>\n\n\n\n Is gratuity taxable?<\/strong> For private sector employees, it is exempt up to Rs. 20 lakh over their lifetime across all employers. Amounts above that are taxed at the individual’s slab rate. Government employees receive it fully tax free.<\/p>\n\n\n\n Can an employer deny gratuity to an eligible employee?<\/strong> Only in narrow circumstances involving misconduct such as violence, willful property damage, or an offense involving moral turpitude, and even then it requires proper documentation.<\/p>\n\n\n\n Do contract or fixed-term employees get gratuity now?<\/strong> Yes, since November 2025, fixed-term employees are eligible for pro-rata gratuity after 1 year of continuous service, a significant change from the previous 5 year requirement that applied to everyone equally.<\/p>\n\n\n\n What happens if my company has fewer than 10 employees?<\/strong> The statutory obligation under the Act does not apply, though nothing stops an employer from paying gratuity voluntarily. In that case, the calculation typically uses a divisor of 30 instead of 26.<\/p>\n\n\n\n How is gratuity calculated for someone who served a partial final year?<\/strong> If the additional service beyond a completed year exceeds 6 months, it rounds up to a full year for the purpose of the calculation. Six months or less rounds down.<\/p>\n\n\n\n Formulas are easier to apply than to memorize correctly, especially once rounding rules and the 50% wages adjustment enter the picture. The Gratuity Calculator handles the full calculation for you, including the standard and non-covered formulas, so you can check exact figures for resignations, retirements, or fixed-term exits without doing the arithmetic by hand.<\/p>\n\n\n\n Gratuity math is not complicated once you know the rules. The part that trips up most small businesses is not the formula itself, but keeping up with which rules currently apply, and to which employees. Bookmark this guide, and when a resignation letter lands on your desk, come back and run the numbers properly.<\/p>\n","protected":false},"excerpt":{"rendered":" If you run a small business in India with ten or more employees, gratuity is not optional. It is a statutory payment owed to eligible employees when they leave your company, and getting the calculation wrong is one of the most common (and expensive) payroll mistakes small employers make. This guide walks through exactly who […]<\/p>\n","protected":false},"author":1,"featured_media":53,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[4],"tags":[],"class_list":["post-21","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-employee-help"],"_links":{"self":[{"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/posts\/21","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/comments?post=21"}],"version-history":[{"count":3,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/posts\/21\/revisions"}],"predecessor-version":[{"id":92,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/posts\/21\/revisions\/92"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/media\/53"}],"wp:attachment":[{"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/media?parent=21"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/categories?post=21"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/smallhrtools.com\/blog\/wp-json\/wp\/v2\/tags?post=21"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}Worked Examples<\/h2>\n\n\n\n
Example 1: Standard Resignation<\/h3>\n\n\n\n
Example 2: Partial Year, Rounding in Both Directions<\/h3>\n\n\n\n
Example 3: Fixed-Term Employee Under the New Rule<\/h3>\n\n\n\n
How Gratuity Is Taxed<\/h2>\n\n\n\n
When Can Gratuity Be Forfeited?<\/h2>\n\n\n\n
\n
Common Mistakes Small Businesses Make<\/h2>\n\n\n\n
Frequently Asked Questions<\/h2>\n\n\n\n
Calculate Your Own Numbers<\/h2>\n\n\n\n